The Crisis, Wall Street and Main Street
Although I supported the initial bailout bill, as did most authors here at PoliGazette, I consider it important to point out reasonable yet critical voices. Our very own Bal(t)imoron is such a voice, of course, and has published several posts critical of the bailout plan, and offering possible alternatives.
Another article critical of the bailout plan deserving of attention is this one written by Arnold Kling.
Kling believes that Main Street does not fully understand just how bad the plan is. According to him, it is an attempt to rescue financial institutions which will, however, hurt and continue to hurt the economy. The financial markets, he says, are overdeveloped. They need to shrink. However, the bailout plan protects financial institutions that are a drain on the U.S. economy.
Today, if anything, we have an overdeveloped financial sector. Harvard economics professor Kenneth Rogoff, former chief economist at the International Monetary Fund, believes that the financial sector in the United States is bloated and needs to shrink. The ongoing consolidation in finance has even further to go, in his view. While this is unpleasant for those who work in the field, it is necessary to achieve better balance in our overall economy. We could see a large reduction in the number of firms and the number of people employed in financial services without impairing households’ ability to invest safely or obtain credit that they can use prudently.
Rogoff views the financial bailout as akin to a tariff for the steel industry or a subsidy for the auto industry. It is testimony more to the power of the financial industry’s political connections than to its role in the economy. Banks are important, yes. But so are manufacturing firms and software companies. Rogoff points out that when the Internet bubble popped, we did not send government aid to the technology industry, which has since recovered nicely following a shakeout.
The other claim that is made on behalf of the bailout is that Treasury will make a profit for taxpayers by buying distressed mortgage-related assets. However, this claim is being made by the same people who did not see the crisis coming, in large part because they do not understand how the values of these sorts of securities behave.
Harvard finance professor Robert Merton, a Nobel laureate, notes that one of the problems at large financial institutions is the gap between the executives and the financial engineers, or what I call the “suits” and the “geeks.” The geeks possess knowledge that is highly specialized and extremely technical. Many suits have never even taken a course in the fundamentals of valuing complex financial instruments, even though the health of their firms depends crucially on that very issue.
Today, the suits are saying that mortgage-backed securities are undervalued, and that if the government just holds them to maturity it will make a profit. But the geeks will tell you that we cannot be certain these securities are undervalued.
That last point implies the following: the bailout may either cause ‘Main Street’ to suffer, or it may not do much. But ‘profiting’ from it is highly unlikely, according to Kling and the professors he cited.
The bailout plan then:
isn’t as bad as Main Street thinks. It’s worse.
We will find out whether Kling is right or not in the coming years.
I actually agree with some of the criticisms of the plan, and I think many financial experts would agree with the professor above. Yes, financial sector is overdeveloped, bloated, and it needs to shrink. That’s what I thought when I was working in one of those failed investment banks. (I left much earlier than the current crisis).
You don’t need to be a genius to figure out how overbloated and overpaid these people are for contributing nothing of value to society at large. But hey, you’re facing many layoffs in the industry as of now and in the following days and months to come.
It is crucial that the government pay fair value for those distressed securities and not pay more than what they are worth. It will be a challenge because a lot of those institutions holding these securities would like to get as good of a deal as possible. That’s why how the plan gets executed will be of paramount importance. Whether enough punitive measures will be enforced throughout these organizations or whether the management will really be stripped of their golden parachutes is not all that clear.
Also it’s important that institutions that are supposed to fail indeed do so without being kept afloat in defiance of market forces so to speak. But all this needs to be done while trying to keep the fabric of the financial system intact, which is why the plan was an important step in the right direction. However the critics of this plan should be loud and clear despite the fact that this plan was a necessity.
People in charge of this plan should know that Americans expect accountability - and perhaps more explaining as to why this was necessary. I also concede that the plan details and execution should be followed in a hawkish fashion so that public money doesn’t get wasted in some special interest financial deals or in bad debts or overpaid securities of institutions that were supposed to fail.
I disagreed with the bailout plan precisely because getting a fair price on all this commercial paper will now be impossible under Treasury reverse-auctions, and that the purpose is to maintain the system. I agree with Nassim Taleb, that the government should not intervene to make the financial sector more efficient, but backstop it against the inevitable crises, and as Yves Smith argued, provide more transparency and safety.
Americans have opted for a mallet when a scalpel was necessary.
How much these securities are worth is the 700 billion dollar question. When markets break down, it may look like they are worth zero dollars because no one is willing to bid any money. So the balance sheets of these banks have imploded. Lack of confidence and unwillingness to buy or sell will cause a lot more to break down due to domino effect. But we know that these securities are worth something because the houses they are based on are definitely worth money regardless of how bad things may get.
As it stands, Paulson is getting ready to subcontract at least 10 fixed income management firms in order to start executing the plan. Under such subcontracting, these firms will come up with valuations on what these securities are truly worth. That’s actually Treasury’s only option, because only experienced derivatives professionals can come up with the proper values for these instruments, not the governement. So I’m not pessimistic and I know that these people will do a good job for the government. If executed well, the Treasury will definitely pay the proper price for these securities. As the only buyer, and it can set its price. If "bailed out" firms don’t like the deal, they don’t have to participate in it.
Well, we see that things aren’t working out so well right now. The band-aid the experts put said we should immediately out on this wound didn’t stop the wound from being infected. In fact, the band aid is getting the wound more infected. I don’t understand all the ins and outs of asset-backed securities or lending business to see this rescue package as of yet, hasn’t panned out as hoped. As a result of the bailout, now banks are hoarding their money, and not lending as much. Maybe they will release some money for lending, maybe they won’t. But it really doesn’t matter. Once again, It is more of a problem of trust with the so-called experts. And once again, we closed our eyes and put our trust in the so-called “experts” who rushed this along using scare tactics, and we hoped they were right, yet gain, apparently they were wrong. (Plus I haven’t even mentioned that other viable ideas were not even allowed on the table) Right before the rescue bill passed, WAMU was bought by JP Morgan, WITHOUT missing a beat, WITHOUT bailout money. Where was the systemic crisis after this? When will we ever learn?
Good read…
http://www.fool.com/investing/dividends-income/2008/09/30/the-beauty-of-washington-mutuals-collapse.aspx
I’m still holding on to hope, but I’d like to see things getting better, not worse.